Europe FOREX and Global Markets – Winter 1997

FOREX and
Global Markets

Winter 1997

A Few Home Truths about Volatility

by Martin A. Armstrong, Princeton Economic Institute

Markets all around the world are starting to experience greater spasms on volatility, both overnight and intraday. There comes a time with big trends when a battle between generations emerges that can be classified as the experienced vs. the inexperienced. Perhaps you have to grow old gracefully in the marketplace before you begin to notice subtle things about trends that can only be explained by the generations cycle.

The one thing that jumps out at you over time is just how very young the industry tends to be. The vast majority of fund managers today are under 30-years-old: they were not even in the business back in 1987. Most will watch their careers crash and burn on the next big shakeout. Wall Street shed some 50,000 job in New York following the 1987 Crash. Those of us who hang on beyond the 20-year mark, meanwhile, may tend to over-analyze every little nuance the marketplace enjoys creating.

Whatever the case, the eternal quest to figure out volatility simply takes time. There are countless little tricks which the market plays in order to accomplish its main goal—maximum entropy. this simply means the marketplace teaches a very basic lesson in life to each generation. As we grow older and begin to learn the game, we start to gather experience from each mistake made in dealing with this beast. So, while in 1966 I was one of those who bought the high-print, by 1974 I was selling the high-print. By 1980, I was daring enough to try going short, and by 1987, I sold the high and reversed at the low to go long. My great trade in 1987 would not have been possible unless I lost almost everything in 1966. This is the cycle of life that everyone has to go through.

Volatility enters the game on two basic levels. First, there is the generational aspect of the business cycle. There appears to be a point in the economy where there is a big rally in investments during the lifecycle of every generation, usually when middle age creeps in for the majority. The young players are often the children of this generation. Fore example, I was very young in 1966 playing in a stock market that was the peak for my father’s generation. As the post-depression generation approached middle age, we came upon the 1974 and 1980 booms and busts. As the war generation approached middle age we came upon the 1987 Crash. Now, as the baby-boomers approach middle age, we are coming upon the 1997 “new era” in investing.

The current levels of high volatility intraday appear as the generations clash head-to-head. The older guys cannot believe the current levels, and attempt shorts. The young guys rush in to buy at every dip, because that has worked every time so far throughout their 4-year career. The mere fact that such wild volatility exists confirms that the battle is not over just yet.

There is also the deeper-rooted volatility created within the system by governments. This volatility is the most dangerous for society as a while, since it is capable of undermining market mechanisms, toppling regimes, and even sparking wars. Such booms and busts are less frequent than those attributable to the generational aspect. Governments, regardless of their constitution or form, may begin as creations of the people, but they always, and without exception, mutate into self-serving enterprises that prey upon the people for subsistence. Read any history book. For thousands of years, governments have existed believing that they had the diving right to preside over mankind. Not one has survived. Dictatorships and monarchies are usually toppled by the people they govern, but democracies fall through their own internal corruption, which acts like a cancer eating away at the rights of the individual.P>

The great booms and busts unleashed by governments are always the most memorable. Despite the popular belief that the Great Depression of the 1930s was created by speculators, it was in fact the consequence of massive government default on obligations worldwide. All of Europe permanently defaulted on their debts (with the exception of Switzerland, while the UK entered a moratorium for 6 months), as did Russia, South America and most of Asia, including China.

The volatility introduced into the marketplace by the silent decline in the confidence of government has always been the worst. This same silent yet deadly force is at work behind the scenes of our current rise in volatility. Two problems are the direct cause:

inaccurate and false economic statistics;

the unification of Europe.

Inaccurate and false economic statistics are creating confusion on an unprecedented scale. Trade statistics are not adjusted for inflation. Currency movements have confused government officials, particularly in the US/Japan trade debate. This serious problem becomes exaggerated when currencies swing 40% in two years, making the statistics worthless, and traders try to make investment decisions based upon such flawed statistics. Making matters worse, trade has become dwarfed by investment capital flows to the point that it represents less than 10% of total capital flows today. The media only stirs the pot of confusion by failing to understand what is going on and feeding the false information around the world. Net capital flows still pour out of Japan because of its own economic depression, with interest rates of less than 10% and stocks continuing to decline, along with real estate. These capital outflows are pushing the yen ever lower. But the political comments confuse the short-term traders, who suddenly panic and rush to sell dollars when the real trend has not changed.P>The unification of Europe is also adding to volatility by destroying long-term investment. Politicians believe that, by not determining a fixed exchange rate for their currencies in advance, they are preventing speculators from profiting. In fact, they are ensuring that volatility will dominate the entire transition period, leaving capital to change its view as to the future value of the euro. Making matters even worse, smarkt capital has figured out that it is the governments who will profit from the creation of the euro, nto the public. Since all European debt will automatically be swapped for Euro-demoniated debt, any depreciation in the currencies between now and 2002 will result in a windfall profit for most governments, particularly Germany and France, whose national debts will be automatically devalued.

The euro represents the worse possible threat to capital—uncertainty. In Britain, when New Labour won, subtle comments about possibly joining EMU sent the pound collapsing against the dollar overnight, and the capital flows that were headed into Britain as a safe haven within Europe moved into the dollar.

Corporations cannot issue 5-year paper in a European currency, nor can they borrow in the euro today, so capital has no place to run to but the dollar. Traders think that raising interest rates in Germany will help, but they are wrong. The issue here is much more serious than where capital can make the best return. What is the final value of the euro? The deutschmark has been transformed into an option on the euro without a strike price! Then there is the heated debate over inflation. Many people continue to argue that inflation is dead, in order to justify being bullish on the stock market. What they are failing to grasp is the fact that all booms come on the back of real inflation in the value of assets. Because assets (stocks and real estate) are not part of the inflation indexes, people become confused buying stock, since apparently there is no inflation, but in fact they are creating asset inflation themselves. Consequently, we have watched the US national debt explode from US$1 trillion to US$6 trillion since 1980. Obviously, there is a US$5 trillion more in bonds in the marketplace today than in 1980, but government has manipulated the CPI (consumer price index) for years. If the old-fashioned definition of inflation is used (too much cash chasing too few goods), then a light appears at the end of the tunnel. By removing all assets from the CPI index in 1983 (such as real estate, which accounted for 40% of the statistic), the government has been able to create the illusion that there is no inflation for the sole purpose of fudging the cost of living increases in its entitlement programmes. Since assets are no longer part of the CPI index, they are free to explode in value, while government denies the inflationary aspects of their fiscal management..

The fact that the Dow Jones Industrials rose from 1,000 in 1980 to 8,000 by 1997 is not a testament to a new ear of low inflation, but rather a confirmation that we have entered the era of “asset inflation.” Real estate is back at its old highs, and climbing. Corporate profits are still reasonable, and book value (a measurement of asset inflation does support the Dow being above at lest the 6,000 level. The irony is that most people do not have a clue as to the full extent to which the statistics have been altered, and to which they are participating in an trend.

While it is believed that higher interest rates will lead to lower stock prices, the true relationship between interest rates and stocks goes largely ignored. By perpetuating the whole myth of no inflation, the market sits on the edge of its seat waiting to exhale every time the Federal Reserve meets. It is focused exclusively upon interest rates, and ignores the historical relationship between the two. If low or declining interest rates were bullish for stocks, then surely we should not have been in a bull market for the past 4 years, during which the Fed raised rates 8 times. The Nikkei should be at an all-time record high, with interest rates below 1%. The Great Depression should never have happened, since interest rates declined fropm 6.5% at the peak in 1929, and bottomed in 1932 with the stock market at 1%. In fact, when one steps back and looks at a photograph instead of a mirror, one gains a better sense of perspective.

Bull markets unfold with rising interest rates, bear markets with declining interest rates. Bull markets occur when corporate profits are expanding and yields rise, leading to greater demand for capital. Consequently, stocks rise in value along with interest rates. Only towards the end of this cycle, when government gets involved, do we find central bands raising interest rates artificially beyond all sense of value. At that moment, capital begins to sell stock (uncertain yield) and buy bonds (guaranteed yield). Interest rates naturally begin to decline after the economic boom peaks, but stocks still fall due to declining book values, corporate profits and, in some cases, the threat of insolvency.

The volatility that we now face is something we have been forecasting would appear in the late 1990s and reach a peak in 2003. While, in part, this volatility is being created by the generational gap in experience on a daily to intraday basis, we are also suffering from the much more severe type of volatility that can be created only by governments. Five years ago, institutions used to request a forecast for 10 to 15 years. Today, our very largest institutions just want to know what is going to happen 6 months out. There is a very serious difference between investment or speculative capital and what we call “real” capital.

“Real” capital is the serious money which underwrites governments. Normally content to buy 10, 20 and 30-year bonds, it does not shift its portfolio for minor daily swings in the marketplace. It is the solid foundation upon which the economy functions, and accounts for more than US$20 trillion dollars. It is this capital which has been shaken, and is most threatened by the conversion of European debt into euro debt without a predetermined value.

Investment or speculative capital, amounting to perhaps a few trillion dollars, moves around with lightening speed, seeking the maximum profit anywhere in the world, measured in days, weeks or months. This is the hot money that pushed the Japanese market to its bubble top in 1989, and broke the Bank of England’s resolve to stay in the ERM. This capital knows no border and holds no allegiance to any political system, philosophy or nation.

Volatility is increasing in intensity month by month as we approach 2003. We have undermined “real” capital, which is uncertain about the future. The boom in the stock market today is not built on the fundamental domestic gibberish of PE ratios and economic statics. Reaching such heights involves more than mutual funds and hot money: it requires the foolish undermining of confidence in the long-term by government itself.